Integrating ESG factors into the investment process: investment decision and agreement

Actions a GP can take to integrate ESG factors into the investment decision and investment agreement

3. Investment decision

Including ESG considerations as standard practice in investment committee discussions will demonstrate to employees that these issues are being taken seriously.

A GP could include key ESG findings collected during the due diligence in the investment memorandum so as to ensure that the investment committee is informed on ESG matters. It may be useful to include this as a separate section in the investment memorandum even if no ESG risks were identified, as it will demonstrate that a thorough focus on ESG matters was performed during due diligence. The ESG findings could indicate how the target company performs relative to its peers.

“Our ESG expert sits in with the Investment Committee to offer any additional information or guidance on a particular topic or industry.”

In practice

Idinvest Partners, a GP headquartered in France, includes an ESG Profile Review of the potential investment in its final investment recommendation. This review highlights all the main findings from ESG due diligence as well as an overall ESG risk assessment score of ‘high’, ‘moderate’ or ‘low’. Idinvest’s investment committee is charged with examining all ESG Profile Reviews for its prospective investments, and will take the ESG risk rating into account when making the investment decision. Investments with a ‘high’ ESG risk rating are excluded.

4. Investment agreement

During investment negotiations with the portfolio company, clear articulation and agreement about the GP’s ESG policies and guidelines can ensure that the portfolio company is aware of the GP’s ESG expectations.

To clarify their ESG expectations to the portfolio company, a GP could:

Leverage industry toolkits for templates on how to integrate ESG clauses into investment agreements. The CDC toolkit, for example, contains such a template.
Seek formal commitment from the portfolio company to adhere to ESG items, an ESG policy or guidelines, for example by including issues identified during due diligence on ESG matters in the 100-day plan. The process for translating due diligence findings into the 100-day plan and/or deal documents will depend on the depth of due diligence carried out prior to closing. A GP may choose to only identify significant ESG risks during due diligence and conduct an in-depth ESG review after the deal has been completed. Alternatively, a GP may conduct extensive due diligence on ESG matters prior to the investment agreement. Regardless of the approach, a GP could incorporate its ESG findings in its dealings with the portfolio company.
Collaborate with the portfolio company management to draft the 100-day plan. This will help to achieve targets which are both meaningful and manageable whilst simultaneously ensuring buy-in from the company management, who are ultimately responsible for executing the plan.
Formulate a roadmap with, for example, a three to five year horizon which identifies clear KPIs, milestones and targets, including possible certification schemes. The plan could also detail the size and nature of the identified ESG risks and opportunities, as well as how these are to be tackled over time.

In practice

Doughty Hanson is an example of a GP which collaborates with portfolio company management to identify, manage and act upon ESG risks and opportunities. This takes the form of an ongoing action plan specifically designed to be flexible and capture information on an on-going basis whilst taking into account change management. If issues arise or are identified which were not in the original action plan, they are simply added to it. In addition, Doughty Hanson seeks to play an active supporting role in the event of an ESG incident or crisis.

In certain cases the issues identified during the due diligence phase provide grounds to increase the monitoring of certain ESG issues. During the due diligence process for one of its portfolio companies, Direct Capital, a GP headquartered in New Zealand, realised that the company had experienced some health and safety issues in the past. Based on this finding, Direct Capital decided to actively benchmark the company’s performance in this area against the entire industry in order to more effectively monitor the situation. Direct Capital will work directly with the board of the portfolio company to establish specific metrics with which to monitor issues such as these. Direct Capital will also exert influence on the portfolio company to report on ESG issues through quarterly board reporting and to regularly monitor alignment with industry standards or e

xternal regulations.